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What is an 'Options payoff diagram'
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Last update : December 2011
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An option payoff diagram is an extremely useful chart that's used by traders to determine how an option or option strategy will move in price depending on different market scenarios such as rising or falling prices in the underlying or different implied volatility levels.
The diagram below is a payoff diagram (sometimes called payoff chart) for a long call option.
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- It shows the maximum potential loss (the horizontal line to the left of A) - long calls (or puts) cannot lose more that their original cost, ie they cannot fall below zero
- But profits are open ended - the 45% line to the right of A because theoretically there's no upper limit for a stock's price
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| The different lines show how the option will perform at expiry ( the solid line), at 1 month till expiry and at 3 months till expiry. |
Option Payoff diagram - Long call
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The next payoff diagram is for a call spread.
- Note how you can instantly see that both the maximum potential profit and loss is fixed because of the horizontal lines to the right of B (profit) and left of A (loss)
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Option Payoff diagram - Call spread
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What is missing from both of these charts is of course the price of the stock. This will be the x-axis (horizontal).
These charts are a central feature of all option software packages including the one I personally use - Hoadley options. See this FAQ for more information.
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